Has it become impossible to choose debt mutual funds for the short term?

Imagine that you are a risk-averse investor and wanted to “park” some money for a few days, and desired to earn a bit more than a savings bank account, an overnight mutual fund is a reasonable choice. If you wanted to extend the investment duration to a few months, a liquid mutual fund is not bad a choice either. Suppose you wanted to invest for a few years, then the usual choice is an ultra-short-term fund. In 2019, it is not possible to take these choices for granted! In fact, it almost appears as if it has become impossible to choose debt mutual funds for the short term!

Risk averse only means that the investor expects the NAV to fluctuate daily but not result in a negative quarterly return (in case of liquid funds) or annual returns with ultra short-term funds. The IL & FS bond degrade in Sep 2018 taught us many lessons: The credit rating of a bond could fall by 9-10 places almost overnight! The NAV of a liquid fund (Principal Cash Management Fund), a money market fund (Tata Money Market Fund), an ultra short-term fund (Motilal Oswal) and even an arbitrage fund (Principal) could drop like a brick because of a rating downgrade As I write this, new came in of an IL & FS SPV bonds degrade affecting funds of UTI and HDFC among others.

Are the AMCs to blame? Yes, they are. Their greed to shift the large AUM “rotting in bank deposits” to debt mutual funds led to (1) giving investors the impression that debt mutual funds are an “alternative” to bank deposits and can fetch higher returns and (2) to achieve this and beat peers, take on higher credit risk.

Are star rating agencies to blame? Yes, they are. They refuse to point out that their star ratings cannot factor in credit risk.

What is the actual problem?

Investors seeking a liquid fund or overnight fund want extra returns compared to a savings bank account but also want no credit risk. This is a reasonable expectation. they are okay with the NAV going up or down every other day by 0.01% and not a 10% overnight fall!

This means, they are looking for a fund with a low interest rate risk and near-zero credit rating risk. This is becoming harder and harder by the day.

Overnight mutual funds fit the bill, but one cannot guarantee that the credit risk is zero. The only advantage here is, even if there is a default, the recovery (for small exposures) will be the quickest. If you settle for these, then returns will also be lower.

There was a time when liquid funds was the automatic choice (overnight funds were then also called liquid funds). However, the IL & FS fiasco has taught us that if the company fails as a whole then all its bonds regardless of duration will fall in rating including those in a liquid fund.

Move away from liquid and overnight funds, the next in terms of duration are the money market funds. Generally, funds here tend to hold A1+ bonds, the highest rating for short-term bonds by CARE. A1 stands for

Instruments with this rating are considered to have very strong degree of safety regarding timely payment of financial obligations. Such instruments carry lowest credit risk.

So A1+ is a bit higher than A1. However, this does not exactly mean “safe” IL& FS short term bonds went from A1(+) –> A1 —> A1(-) —> A2(+) —> A2 —> A2(-) —> A3(+) —> A3 —> A3(-) —>A4(+) —> A4. That is 10 notches overnight on the CARE scale!

The problem is not A1+ dropping to A1 or A1(-) to A2. That will affect the NAV but not cause an Earthquake. The problem is these huge downgrades. Naturally, they are outliers, but it is a real risk and investors will have to account for it.

So we now have evidence of a credit rating downgrade in pretty much every category! Liquid funds, money market funds, ultra-short term, arbitrage, dynamic bond, corporate bond, medium to short duration funds, credit risk funds (which is the only place where it is expected) and even banking and PSU funds.

So the actual problem is, no category is safe! Because practically no debt fund* says in their scheme document (as far as I have seen) that “we will not invest in X or Y type of bonds”. The scheme document is more a license for them to invest anywhere under the sun!

* Quantum Liquid is an exception. It:

does not take exposure in private sector corporations and invest only in government securities, treasury bills and highest quality instruments issued by public sector undertakings (PSU) Source: Quantum Newsletter

Credit rating risk is not the problem. The problem is credit rating risk is not segregated! Except for overnight funds, practically all mutual funds take on credit risk. It is one thing for a A1+ bond to drop 10 grades, but if a fund holds A and AA rating bonds, The fall by a single grade can affect NAV noticeably if the exposure is not small.

So the problem, I cannot find a liquid fund or any other type of debt or hybrid fund that says, “we will only invest AAA or A1+ rated bonds”

Credit risk risk is not a problem because one can take a chance with those for longer investment durations. Even if I hate credit risk, long term gilts will work for long-term goals (5Y +). For short investment durations, I must be able to find a fund that will only invest high-quality bonds. From what I see, this has become pretty much impossible.

Why? Because if AMCs restrict themselves like that, the star ratings will fall (as they are flawed). Remember, a high quality bond will only shell out low interest payout. So the returns will be low and investors will avoid these. Distributors cannot push these.

So the answer to the tittular question is, yes, it become impossible to choose debt mutual funds for the short term … without worrying about credit rating risk

The solution to this simple. How many debt funds should fall and how many investor should suffer for SEBI to introduce short-term gilt category and mandate credit rating limits for overnight, liquid and money market instruments? Easy to say that the investor should be aware of risks, but the regulator, instead of trying to popularize mutual funds, should first make them simpler products!

So what should investors do?

If you are scared of credit risk, avoid all debt mutual funds except overnight and liquid funds that you trust (preferably large AUM) for short term goals. For long term goals, gilt funds will work, but some portfolio management is necessary. We will discuss that in a separate post.

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10 Comments

Good Lord, almost all my life’s savings are in a mix of equity and debt mutual funds. I have split them amongst multiple liquid, low duration and UST funds in similar proportions. The overall returns should be in 7-8 percent with indexation. I did this to spread risk amongst AMCs, fund managers etc and paper held. But all of them except Franklin, hold low risk (notionally) paper. Your point stands regarding how notional that risk is.

All of them have exposure of around 2 percentage to each corporate bond etc. So won’t that mitigate NAV fall?

I mean if the proportion of dodgy paper held is 4 percentage ( assume 2 defaults), won’t the loss be around 4 percentage to 6 percentage (assuming loss premium viz.actual loss).

With huge NPAs, we can’t even rely on Bank FDs especially PSUs. Equally confusing is private bank FDs offered by Yes Bank, Federal and so on which are having huge NPA issues.

For UST, Low Duration, ST funds, stick to >5,000 Cr AUM funds with multiple fund houses. As they have caps to each exposure, one default would not create a wreck in NAV. Some diversification would help at least help protect the capital.

I think I understand how risk works in a debt fund regarding maturity and credit quality. I need to understand the need to invest in a gilt fund at higher risk (due to duration risk) just to get “debt-like” returns. Can I not replicate a gilt fund return by combining a Nifty Index fund with a liquid fund?

Selecting Fund house is critical while selecting a debt fund.There are some funds which have avoided exposure to IL and FS altogether as they were aware that RBI issued a warning in 2015 about the Functioning.

SBI mutual Fund is One Example.Heard about it IN Q and A session.It is essential on the part of an Investor to ask Fund house about the types of papers In which the debt fund are investing and how much Risk it carries.

Before I invested in debt funds, I went through the Sid and holdings of various debt funds and found a significant variation in the kinds of bonds being held from year to year. For instance, one short term debt fund might have bonds that should classify it as a liquid fund while the kind of bonds it holds in the next year should see it classified as a dynamic bond fund. I did also read that while SEBI regulates the classification of equity funds in terms of where they can invest, such regulation is missing in the case of debt funds except liquid funds. This means that a short term bond fund might actually hold longer duration paper to boost returns and return to holdings closer to Sid later. In other words, every debt fund not a liquid fund is effectively a dynamic bond fund!! In sum, I think as a lay investor I am better off investing in either liquid funds or dynamic bond funds. Every other category seems pure eyewash and marketing.

Accrual Fund and duration funds are the Basic Types which a Person should Understand. Accrual Funds ideally focus to earn interest income in terms of coupon offered by Bonds. These are a type of debt funds which typically invest in short to medium maturity papers. Ideally, the funds which follow the Duration based strategy invest in long-term bonds and benefit from the interest rates fall. They earn from capital appreciation along with the coupon of the bond. But, these funds are exposed to interest rate risk and these funds can bear capital losses, if the interest rates move up.

Even if you had a T-bill fund, there is still liquidity risk. What if the other unit holders sell during a liquidity crisis and the fund has to sell t-bills at a loss? The only way to fully safe is to have t-bill FMPs or an overnight fund that parks money with RBI exclusively.